Is This the Way to Solve America's Problems?

By: Motley Fool

Posted: 9/13/2010 9:17:00 AM

Referenced Stocks: COP;GE;HPQ;LLY;MOT;MRK;PFE

After a brief respite, the
economy
is showing signs of faltering again. Government expenditures have
ballooned, while tax revenues are dwindling. Although the massive
intervention during the market meltdown may have helped avoid an
even more extreme collapse in stocks,
people strongly disagree
about what if any role government should play in the future -- and
how long freely available borrowing will allow it to continue
spending more than it brings in.

It's with that backdrop that the President's Economic Recovery
Advisory Board released its report on tax reform last month.
Despite all the uncertainty about what will happen to
individual tax rates
in 2011 and beyond, the report focuses largely on the less
well-understood portion of the federal government's revenue:
corporate taxes.

Free money?
Corporate tax revenue makes up a relatively small part of the
overall federal budget. In the government's 2010 fiscal year,
corporate tax revenues were $176 billion, compared to nearly $1.8
trillion from individual income taxes, combined with payroll tax
collections for Social Security and Medicare.

But the government is counting on
rising corporate tax receipts
to provide a growing share of total revenue going forward. The
Office of Management and Budget projects that corporate tax revenue
will more than double to $415 billion by 2014, compared to more
modest growth on a percentage basis for other revenue sources.
Budget proposals go even further to increase corporate tax revenue
going forward.

The PERAB report sheds some light on how proposed changes could
affect corporate taxation. Although this portion of the report
spans 30 pages, its suggestions boil down to the following:

Corporate tax rates in the U.S. are among the highest in the
world, and lowering them could make U.S. businesses more
competitive.

To make up for lost revenue, broadening the corporate tax
base may be necessary. Possible solutions include eliminating or
reducing certain tax breaks, or forcing other business entities
such as partnerships and LLCs to pay corporate-level tax.

Changes to the way the U.S. taxes international business
operations could reduce the incentives that companies have to
structure their businesses to avoid U.S. taxation entirely.

The report's findings present an interesting dilemma. Cutting
corporate tax rates could boost economic activity, but at the cost
of already scarce tax revenue. Various reform measures could boost
tax revenue, but potentially at the cost of cutting economic
activity. Is there a way to have our cake and eat it, too?

Haves and have-nots
From an investing perspective, shareholders need to know whether
their companies have benefited from the existing corporate tax
structure in order to figure out if a change could hurt them.
Recent tax data is suspect because the recession has had a big
impact on both profits and tax liabilities. But a 2007 study that
looked at effective tax rates from 2004 to 2006 showed that six
companies enjoyed double-digit percentage reductions in their
effective tax rates because of favorable taxes on foreign earnings.
Here they are:

Company

Percentage-Point Reduction in U.S. Tax Rate as
Result of Foreign Earnings

By structuring their operations to take maximum advantage of
favorable foreign jurisdictions, companies like these can reduce or
eliminate U.S. taxes legally while still paying substantial taxes
elsewhere.

Past efforts suggest that reform might work. In 2004, companies
got a favorable tax break if they repatriated money from overseas
operations. As a result, effective tax rates for many companies
increased as they took advantage of the tax provision.
Hewlett-Packard
(
HPQ
) and
Eli Lilly
(
LLY
) each saw their effective tax rates rise by 5 percentage points or
more, with Merck and Pfizer also reporting substantial gains.

The big question
For corporate tax reform to work, companies need to have less
incentive to game the system by strategically placing operations
and assets out of reach of the U.S. government. Lower tax rates
might well accomplish that, especially if accompanied by a change
in the way foreign revenue is taxed. If the best decision for
companies is to pay more tax to the U.S. and less to foreign
governments, then it's a potential win both for those companies and
the U.S. government.

Taxes are complicated, and the coming political fight on these
and countless other tax provisions, including individual income tax
rates, the estate tax, and capital gains and dividends, will be
long and fierce. Keeping an eye on the proceedings, though, can
give you advance notice of changes that could dramatically affect
the stocks you own.

Tune in every Monday and Wednesday for Dan's columns on
retirement, investing, and personal finance.

True to its name, The Motley Fool is made up of a motley
assortment of writers and analysts, each with a unique
perspective; sometimes we agree, sometimes we disagree, but we
all believe in the power of learning from each other through our
Foolish community.

Fool contributorDan Caplingernever met a tax he particularly liked. He doesn't own shares of
the companies mentioned.Pfizer is a
Motley Fool Inside Value
recommendation. The Fool owns shares of Qualcomm. Try any of
our Foolish newsletters today,free for 30 days. The Fool'sdisclosure policywill never need reform.